The Biggest Mistakes People Make With IRA Rollovers

And the mistakes that are commonly made with this kind of transfer of money are also increasing.

These mistakes can be costly, potentially amounting to thousands of dollars, because money in a workplace retirement plan such as a 401(k) often represents one of the largest payments a person can receive.

Rolling these funds directly into a traditional IRA provides flexibility and control without paying immediate taxes, as well as choosing from a variety of investment options such as stocks, bonds, mutual funds, exchange-traded funds, certificates of deposit and annuities. provides the ability to. With the company’s plan, you’re likely to have a limited number of options, perhaps only a half dozen or so.

“We’ve seen an increased frequency of rollovers lately,” says Sarah Brenner, director of retirement education at the tax consulting firm Ed Slott & Company in Rockville Center, NY, “and we’ve seen a lot of questions about how these rollovers happen.” Avoid mistakes.”

Know here some such mistakes.

1) Instead of taking one-time distributions of 401(k) funds directly to the IRA custodian. In such cases, called indirect rollovers, you only have 60 days to deposit them into an IRA. If you miss the deadline, the amount is considered a distribution that will need to be included in your gross income for tax purposes. If you’re under 59, a 10% early-withdrawal penalty may also be imposed on the money you receive. .

However, there is an exception for employees who have highly valued company stock they are leaving in their 401(k). This is called the Net Unrealized Appreciation, or NUA, strategy.

Those employees can take a lump-sum distribution and must pay tax at the ordinary income tax rate — but only on the cost basis, or the adjusted principal value of that stock. The difference between the cost basis and the current market price is the NUA, and they can defer tax on that difference until they sell the stock.

For example, if you paid $30,000 for company stock and it is now worth $90,000, the NUA is $60,000. Even when it comes time to pay, this $60,000 appreciation will be taxed at the long-term capital gains rate.

2) Not realizing that when you do an indirect rollover, your workplace plan administrator will typically withhold 20% of your account and send it to the Internal Revenue Service as a prepayment of federal-income taxes on distributions. This happens even if you plan to deposit money into an IRA immediately. (When you file your tax return in April, you’ll get a refund from the IRS if too much tax was withheld.) So if you want to contribute the same amount to your IRA as your 401(k), you’ll need to. Must be provided funds from other sources to make up for the withheld amount.

3) Rolling funds from a 401(k) into an IRA before taking a required minimum distribution, or RMD. This mistake affects people who are required to take RMDs for the year that they are receiving distributions from 401(k)s — individuals age 72 or older. Doing so will result in an additional contribution, which is subject to an annual 6% penalty until recovery.

4) Not realizing that rolling the funds from a 401(k) to a Roth IRA is considered a conversion and you have to pay taxes immediately. However, if you have after-tax dollars in your 401(k) plan, you can make tax-free distributions of those funds to a Roth IRA. You must hold the funds in a Roth IRA account for at least five years before any earnings can be withdrawn or those earnings will be taxable and potentially subject to penalties.

5) Not knowing there are limits when transferring funds from one IRA to another if you do a 60-day rollover. Generally, you are allowed to roll only one distribution from one IRA to another within a 12-month period, regardless of how many IRAs you have. If you make more than one distribution, it is considered taxable income. And if you’re under 59½, there’s an additional 10% penalty.

According to the IRS, “the limit will apply to all IRAs of an individual, including SEP and SIMPLE IRAs, as well as traditional and Roth IRAs, by effectively treating them as one IRA for the purposes of the limit.”

To ensure a successful rollover, it may be useful to mark a direct trustee-to-trustee transfer as “for the benefit of the IRA owner” rather than an indirect one. Then there would be no 60-day rule or once-a-year rule to worry about.

Mr. Sloane is a writer in New York. He can be reached at reports@wsj.com.